Trading One Risk for Another

There are obviously a number of risks regarding Europe. One of the biggest is the banking system, and how shocks to it can be transmitted through financial markets.

We saw this in 2008 when liquidity dried up and economic turmoil resulted. But that has been widely discussed. I'd like to focus, instead, on trade.

When considering the economic impact of a possible -- even likely -- recession in Europe, direct U.S. exports to the European Union comes to mind. That would be the first, and perhaps most naive, approach. Excluding services, exports of goods are about 10% of the U.S. economy. The EU is our largest export market after Canada, with about $240 billion of goods exports in 2010, or about 19% of total exports. So, the export of goods to the EU accounts for about 2% of GDP.

The U.S. also exports services, which includes movie and entertainment royalties, airfares and financial-services transactions, among other categories. While they are important to U.S. companies, they don't all translate directly into U.S. jobs because there isn't always an incremental need to add staff for additional revenues from these exports. So I'm focusing on goods, considering data from the U.S. Census Bureau break down monthly exports by region for goods but not for services.

From international trade data released Thursday, we learn that since September, U.S. exports of goods to the EU haven't suffered -- at least not yet. Exports to the EU, on the non-seasonally adjusted basis reported by Census for regional export data, rose 3.3% from August and by 14% from September 2010. Among all our trading partners, this compares with a 2% increase of U.S. exports of goods for the month, a 1.4% gain for both goods and services and a 15.9% advance from a year ago. But this was before more serious problems emerged, and these data don't tell us what will happen in the future.

So, how would a recession in the EU affect exports there? If you take a simplistic approach and say our exports of goods to the EU are only about 2% of the total economy, it won't move the needle much here even if the EU contracts a bit, right?

Well, no. There is a different risk that has little to do with demand from Europe: the effect of currency exchange rates in trade. This affects the competitiveness of European manufacturers versus U.S. companies in every single market around the world where there is head-to-head competition, including the U.S.

I'm not making a prediction here; rather, I'm outlining a risk. If the euro depreciates substantially against its trading partners, let's say below $1.15, our price competitiveness based on currency might be at risk. And if there are serious problems in the eurozone, the dollar may strengthen against trading partners, making our goods more expensive globally -- not just compared to European companies, but to others around the world.

There are plenty of examples of U.S. companies competing directly with European counterparts. Remember that there's competition at home, too, in products spanning different categories that include consumer goods and capital goods. They may be as simple as the smallest household personal care product, or as large and complex as an aircraft or piece of heavy industrial equipment.

Consider a few examples of U.S. and European companies that have at least a few products competing directly. I'm not discussing the investment merits of these companies -- I'll leave that up to securities analysts. Rather, I want to make a point.

General Electric (GE) competes with Siemens AG (SI). Boeing (BA) competes with Airbus. Procter & Gamble (PG) shares shelf space with Unilever (UN). I can buy a car from Ford (F) or GM (GM), or I can buy a Toyota (TM) or Volkswagen.

The competition becomes global should the euro weaken substantially. My purpose is not to make a forecast about a particular level of the euro, but to bring another issue into the discussion, where there's a risk of problems in Europe. While the banking system is probably the biggest risk, the challenge a weaker euro presents for U.S. manufacturers is a close second.

As an economist, it's not my role to pick specific companies that will be winners or losers should the euro weaken substantially. I am highlighting a risk rather than making a forecast. I want to bring the topic up for discussion because I believe this aspect of eurozone woes has been overlooked with the intense focus on banking and a recession in Europe.

Instead, the potential risks facing certain parts of the U.S. economy and some companies are more far-reaching should the euro falter.